Article by Judy Kornfeld
(Page 2 of 2)

Method Two: Convert Company Stock to Cash

The second method that is widely used is to convert the shares of employer stock to cash and establish a separate investment account for it. Some companies have chosen this as a way to address their concerns about allowing terminated participants to remain invested in company stock. Company stock is cashed out at its fair market value, typically at the end of the plan year in which the participant terminates employment. A segregated investment account is then established that is invested in appropriately conservative investments until it is time for distributions to begin.[8] While this method avoids the effect of variations in the value of the company stock on terminated participants, it requires cash equal to the amount required for an immediate lump-sum distribution to be available. This is not a problem if sufficient other investments are available in the ESOP trust to "cash out" the terminated participant's account; active participants' other investment accounts would be reduced and their company stock accounts increased to effect the transaction. However, if sufficient cash is not available in the trust, a contribution from the company would be required, which would effectively eliminate the advantage of delayed distributions and installment payouts for the sponsoring company in managing and funding its repurchase obligations.

Method Three: Create a "Phantom" Cash Account

There is a third method of handling this issue, a method for which some ESOP companies have obtained favorable determination letters from the IRS but which most ESOP practitioners believe is extremely dangerous. This method has the company create an account for a terminated participant based on the value of the company stock and other investments at the end of the plan year during which termination occurred. There is no actual transfer of cash; it is essentially a phantom account. Interest at a specified rate (either a fixed rate or a rate that is indexed externally) is credited to the account until distribution occurs. The shares that are "cashed out" of the terminated participant's account are reallocated to active participants' accounts.

This method succeeds in avoiding the effect of changes in the stock value on terminated participants, while allowing the company to fix the price at which it will repurchase the stock without having to provide the cash equivalent of a full and immediate lump-sum distribution. It presumably would be used in situations where the ESOP trust does not have sufficient liquidity to create an actual cash account. It accomplishes the otherwise conflicting objectives of cashing participants out of company stock immediately without having the large, immediate cash requirement associated with the first method. However, it creates a problem in properly accounting for plan assets and liabilities as well as some serious fiduciary issues that appear to be associated with the creation of an unfunded liability for the plan.

The accounting problem arises when cashed-out shares are reallocated to active participants. This results in total account balances for active and terminated participants that exceed actual plan assets by the amount of the phantom accounts and creates, in practical effect, an unfunded plan liability. The size of this unfunded liability will grow if the interest rate being credited to the phantom accounts is higher than the rate at which the value of company stock held by the ESOP is appreciating and can become very large, especially if the value of the company stock declines. In some instances, to balance plan assets and liabilities, a negative entry is made in active participants' "other investment" accounts to offset the value of the cashed-out shares, i.e., allocating the unfunded liability to the active participants' accounts. To keep the assets and liabilities in balance, these negative other investment accounts must grow (i.e., become larger negative amounts) at the same rate as the phantom cash accounts of the terminated participants are growing. In theory, the negative balances would be eliminated when the company actually contributes cash to the ESOP trust to make a distribution to the terminated participant.

Problems would arise, however, if the company were unable to provide the cash needed for distributions and the value of the company stock had declined, as might be the case if the company suffered financial setbacks between the time the phantom account was established and the time a distribution was required. The value of the "phantom" accounts would have continued to grow while the value of the actual plan assets would have declined, causing an increase in the size of the unfunded liability. The author has been informed of at least two instances where the Department of Labor has sued ESOP plan fiduciaries under such circumstances on the basis that the creation of an unfunded liability constituted a breach of fiduciary duty.

Method Four: Exchange Common for Preferred Stock

A fourth method is available that accomplishes the objectives of fixing the terminated participant's account value without requiring immediate cash. At the time a participant terminates, his or her company stock can be exchanged for a non-convertible preferred stock, in which the account would remain invested until distributions begin. The dividends on the preferred stock would be paid in kind, and the preferred stock would be redeemed at the time distributions begin. The preferred stock could be designed to minimize potential fluctuations in value, and it should certainly fluctuate less than common stock. The company would not have to provide cash until distributions begin. Unlike the third method, the "cash-out" transactions would not create negative other investment accounts for the active participants because the exchange of common for preferred stock would not affect their accounts. While this may be "cleaner" than the third method, it does have the disadvantages of being more complicated and more expensive. The dividend on the preferred stock would almost certainly have to be higher than the interest rate that would be credited to the terminated participant's account under the third method, and there would also be the expense of having annual valuations of the preferred stock.

Conclusion

There are several alternatives from which a company may choose concerning the way it handles company stock in the accounts of terminated participants. Which one is most appropriate depends on the requirements of the plan, the law, and the company's philosophy about leaving terminated participants invested in company stock and its ability to provide liquidity to the ESOP trust. If sufficient cash resources are available from current contributions or accumulated other investments within the trust, the "cleanest" way to handle a terminated participant's account, if the company does not want terminated participants to remain invested in company stock, is to use Method Two, i.e., to create a cash account. If there is insufficient liquidity in the trust, the alternatives are either complicated, dangerous, or require leaving the terminated participant invested in company stock. Perhaps this article will initiate a discussion among ESOP practitioners about additional planning ideas that may be available, as well as making ESOP companies aware of some of the issues associated with the choice of cash-out methods.

Notes

8. The National Center for Employee Ownership's model ESOP plan document uses a hybrid of Methods One and Two. It allows the participant's account to be cashed out of company stock only if the participant fails to consent to a distribution before age 65. [return to text]

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